Germany: Selected Issues
Author: International Monetary Fund
Publication Date:
11 Nov 1997
eISBN:
9781451810318
Language:
English
Keywords:
ISCR; CR; enterprise; Länder; replacement rate; tax relief; tax reform; single tax; taxable income; withholding tax; Income; Personal income; Personal income tax; Corporate income tax; Marginal effective tax rate; Global
Download PDF (2.3 MB)

This Selected Issues paper analyzes labor market asymmetries and macroeconomic adjustment in Germany. Empirical work reported shows that in Germany, negative demand shocks increase the unemployment rate by more than the decrease in the unemployment rate caused by a comparable-sized positive demand shock. The contribution of labor costs to explaining the high level of unemployment, particularly since unification, is studied. Empirical estimates are obtained for the wage gap—the deviation of actual labor costs from warranted labor costs based on estimated production functions assuming competitive factor markets and full employment.

Abstract

This Selected Issues paper analyzes labor market asymmetries and macroeconomic adjustment in Germany. Empirical work reported shows that in Germany, negative demand shocks increase the unemployment rate by more than the decrease in the unemployment rate caused by a comparable-sized positive demand shock. The contribution of labor costs to explaining the high level of unemployment, particularly since unification, is studied. Empirical estimates are obtained for the wage gap—the deviation of actual labor costs from warranted labor costs based on estimated production functions assuming competitive factor markets and full employment.

IV. Tax Reform in Germany1

A. Introduction and Overview

128. Weak macroeconomic performance, including record high unemployment and sluggish growth, and an erosion of the tax yield have made it more difficult for the Government to meet its fiscal objectives in recent years and have brought the weaknesses in the German income tax code to the fore. By comparison with the rest of the OECD, Germany places a higher burden of taxation on labor income and a lower tax burden on capital income. Indeed, distortions from the uneven taxation of income from labor and capital and the lack of transparency (given the multiplicity of exemptions and allowances) in the tax code have helped to skew output growth toward higher capital intensity and away from relatively high-cost labor. With the presence of international tax competition, large German corporations have increasingly booked their profits abroad in countries with lower corporate tax rates. The globalization of manufacturing has also made decisions concerning production location more sensitive to relative costs, including taxes. Consequently, shifts in income and demand patterns have contributed to an erosion of tax revenues and have made revenue projections less reliable.

129. The German income tax code is characterized by numerous tax breaks motivated by economic and social policy objectives, by a personal income tax schedule with a high entry hurdle at the low end and very high marginal rates at the top end, and by unequal taxation of different types of income (e.g., wage income, business income, capital gains). The resulting tax arbitrage possibilities have led to a marked deterioration in taxes on assessed income and corporate income over the years. The tax rules are too complex and relatively opaque—to the point of undermining government tax estimates and the conduct of fiscal policy. The proliferation of preferential rules—not least in connection with support for the new Länder—have distorted investment decisions, while the extensive use of tax shelters has created the perception of a lack of tax equity.

130. These elements have contributed to a relatively low effective tax yield from corporate and nonwage incomes, while the reliance on wage taxes (and social security contributions) has been high and rising (Chart IV-1). By international standards, the effective tax rate on labor income in Germany is among the highest in the G-7 countries, while the effective tax on capital is relatively low. The high taxation of labor (both wage taxes and social security contributions) has contributed to labor-saving technologies and less employment intensive growth—and thus ultimately to lower revenues and larger social expenditures.

CHART IV-1
CHART IV-1

GERMANY Wage and Profit Tax Ratios

(In percent)

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A004

Source; Deutsche Bundesbank and staff calculations.1/ Profit taxes are defined here as consisting of the assessed income tax, the corporate tax, capital income tax, and local trading tax. The ratio is expressed as percent of gross entrepreneurial and property income.2/ The wage tax ratio is calculated as wage tax receipts divided by gross compensation from dependent employment.

131. To address these shortcomings, in early 1997 the Income Tax Reform Commission headed by Finance Minister Waigel (the Waigel Commission) presented proposals to reform the income tax system; these would take full effect in 1999. The proposals envisaged (a) reducing the top marginal income tax rate from 53 percent to 39 percent2, (b) lowering the corporate income tax rate on retained earnings from 45 percent to 35 percent, and (c) cutting tax allowances, reducing depreciation rules, and tightening corporate accounting rules. The local trading tax on capital would also be abolished. Part of the income tax relief would be financed by an increase in indirect taxes, which would effectively shift the tax burden toward consumption taxes. In total, these measures would result in net tax relief of ¾ percent of GDP in 1999.3 With some amendments, the Waigel Commission proposals were incorporated into legislation that passed the Bundestag—Germany’s Lower House—in June 1997. This legislation, however, was vetoed in the Bundesrat—the Upper House—where the opposition SPD has a majority. A mediation committee of both houses of Parliament failed to reach a compromise in late July. But the Government intends to resubmit a tax reform package to Parliament in September.

132. The Government’s reform initiative—following a pattern pursued in many other countries—seeks to lower marginal income tax rates, while broadening the tax base. Though optimal tax theory suggests that some differentiation in the tax base may be desirable, the Government’s tax reform plan is motivated by the conviction that a comprehensive tax base with fewer preferential rules and lower marginal tax rates would improve equity, simplicity, and efficiency. Although the reform proposals (unlike the 1986 tax reform in the United States4) are not designed to be distributionally neutral, vertical equity would be broadly maintained—despite lowering the top marginal tax rate substantially—by closing tax shelters and imposing a slightly greater tax burden on the corporate sector. More importantly, the elimination of special tax preferences and opportunities for tax avoidance would improve horizontal equity. Not only would the elimination of special tax preferences improve the simplicity of the tax code directly, lower marginal tax rates would also reduce incentives to engage in complicated transactions purely for tax reasons. A broader tax base and a more uniform taxation of different types of income would also reduce the scope for tax arbitrage and improve efficiency—in particular by reducing the tax-induced misallocation of investment. More generally, the tax reform aims at improving supply-side conditions and enhancing Germany’s international standing as a location for production.

133. In Germany, statutory corporate tax rates, which are high by international standards, have attracted much attention and have reportedly even influenced Standort decisions, i.e. the location of investment. But while statutory rates are high, the effective corporate tax rate is not high internationally, owing to an exceptionally narrow corporate tax base caused by generous depreciation allowances and liberal accounting standards. (In fact, in some studies the effective corporate tax rate in Germany is found to be the lowest among the G-7 countries.) The Government’s reform proposal would rebalance the relationship between tax rates and the tax base, and bring it more into line with international standards by reducing tax rates, while lowering depreciation allowances and tightening accounting rules. On balance, although the tax burden on the corporate sector would rise slightly, the proposed changes would lower the marginal tax burden on investment—albeit with some variation across industries.

134. In contrast to corporate tax rates, the top marginal tax rate on personal income (53 percent) is close to the international average, but the entry marginal tax rate (25.9 percent) is high by international standards. Moreover, the tax code contains structural weaknesses (such as differential taxation of income from different sources) that offer broad scope for tax arbitrage and that have narrowed the tax base—especially as high-income earners appear to have been increasingly able to shelter their taxable incomes.5 These tax avoidance strategies are facilitated by the tax exemption of capital gains on personal assets. It is generally recognized that the income tax code has increasingly been overburdened with provisions motivated by economic and social policy objectives that have severely reduced the transparency of the tax system and have contributed to a public perception of horizontal inequity.

135. The reform plan is guided by sound principles: reductions in marginal tax rates, a broadening of the tax base, and a shift from direct to indirect taxation. The significant reduction in marginal income tax rates would improve incentives generally: at the lower end of the income distribution, it would help alleviate unemployment traps; at the upper end of the income distribution it would reduce the incentive for tax avoidance. Although many tax shelters would be eliminated, tax allowances reduced, and accounting rules tightened, the plan leaves scope for a further broadening of the income tax base, both on personal and corporate income.

136. The reform plan also constitutes progress toward improving the equity, efficiency, and simplicity of the tax code. The effects on vertical equity stemming from lowering marginal tax rates would be cushioned by reducing the scope of tax shelters that have primarily benefitted high-income earners. The smaller room for tax avoidance and the reduction of special tax preferences would also create the perception of improved horizontal fairness. The tax reform proposals are a welcome step toward rebalancing the focus of taxation away from income taxes, which have fallen increasingly on wages, toward consumption taxes. This shift would both solidify the tax base and promote saving. Moreover, the proposed reduction in corporate tax rates in combination with a more transparent calculation of profits would improve the allocation of capital. Staff analysis suggests that the simultaneous cut in corporate (and personal) tax rates and the scaling back of depreciation allowances would lower the marginal effective tax rates on investment and would lessen the distortions among different types of investment and modes of finance. These calculations also indicate that the proposed tax reform—by reducing effective marginal tax rates—could be expected to boost investment despite less favorable depreciation allowances. Nonetheless, enterprises that are heavy users of capital would be adversely affected by the broadening of the tax base. Rental housing would face a markedly higher tax burden as a result of less generous depreciation rules and the longer holding period required to qualify for tax-exempt capital gains.

137. The overall macroeconomic effects of the proposed tax reform would depend on the ultimate magnitude of the net tax relief (currently about % percent of GDP) and how it would be financed. The short-run demand impact would be positive. Over the longer run, assuming that some of the net income tax relief would dampen labor costs, the lower effective tax rates on investment and the shift to consumption taxes would likely raise both output and employment. Lower labor costs would tend to reverse recent trends in the capital-labor ratio, improve the marginal productivity of capital and thus stimulate capital accumulation and growth.

138. The tax reform plan, however, falls short in at least three respects. One, the unequal treatment of different types of income and substantial tax loopholes would remain. In particular, the differential tax treatment of personal and business incomes and of capital gains would maintain incentives for income shifting to lessen the tax burden. The reluctance to tax capital gains on personal assets (gains on business assets are subject to taxation) permits the continued sheltering of taxable income. Such income shifting—helped by the special tax breaks for investment in eastern Germany—is highly regressive and appears to have contributed to the erosion of the personal income tax base in the 1990s. Two, the tax treatment of provisioning for old age pensions, through the publicly run occupational pension funds as well as private, or company, pension funds should be streamlined and contributions should be made fully tax deductible. At the same time, pension income should be taxed as ordinary income. Three, the proposed reform does not directly address issues concerning the taxation of resident and non-resident corporations. This could pose problems particularly as regards the single internal market within the EU and intensifying international tax competition.

139. This chapter is organized as follows. In the next section, the current German income tax code is described, and it is placed in an international perspective in section C. The main elements of the Government’s tax reform proposals are presented in section D, and the economic effects of the proposed tax reform are discussed in section E.

B. The Current Code of the German Income Tax

140. Despite a three-stage income tax reform in the second half of the 1980s (which flattened the marginal tax rate schedule and raised basic tax allowances), the income tax code has become increasingly complex, the tax base has narrowed owing to numerous tax breaks, and marginal tax rates remain high.6 The key features of the income tax code and related issues are:

• The 1996 Tax Act by increasing the basic tax exemption to the level of subsistence income created a high hurdle at the entry marginal tax rate; the marginal tax rate for upper incomes is high internationally.

• The tax code contains a large number of tax breaks, most designed to promote non-fiscal objectives.

• Many of the tax rules, primarily those motivated by special economic objectives, have severely reduced the transparency of the tax system.

• Under the current tax code, different types of income are de facto not taxed equally (e.g., ordinary personal income, business income, capital gains), widening the scope for tax arbitrage.

• The taxation of pension income and life insurance payouts is not consistent with the correspondence principle, according to which contributions would be tax exempt and future income would be fully taxed.

• The increased globalization of corporate activities, including international tax shifting, tax avoidance and the erosion of the tax base have contributed to declining tax revenues and less reliable tax estimates, complicating fiscal management.

141. The schedule of income tax rates has high entry and top marginal tax rates. The tax reform of the late 1980s established a “linear-progressive” marginal tax rate schedule and eliminated the bulge in the middle-income range. The 1996 Tax Act created, however, a hurdle at the lower end of the tax schedule by raising the entry tax rate from 19.0 percent to 25.9 percent (Chart IV-2). At the same time, the basic personal tax exemption was raised from DM 5,616 to the subsistence income of DM 12,042. The high top marginal tax rate (53 percent at incomes of DM 120,000 for a single tax payer and DM 240,000 for a one-earner married couple)—in combination with the differential taxation of various types of income—exerted strong incentives for tax avoidance that fell on fertile ground given the numerous possibilities for sheltering income by investing in the new Länder and some selected sectors (e.g., shipbuilding).

Chart IV-2
Chart IV-2

Germany Personal Income Tax Schedules

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A004

142. Under the present tax code, different types of income are de facto not taxed equally. The top marginal income tax rate on ordinary personal income is 53 percent/57 percent (including the solidarity surcharge on income taxes) compared with marginal tax rates on business income (gewerbliche Einkünfte) of 47 percent/50.5 percent and on retained earnings (Thesaurierungssatz) of 45 percent.7 Business income is additionally subject to a local trading tax on profits. This tax, in combination with the trading tax on capital, is the most important tax for municipalities. The tax rate on profits is set by local governments and can reach as high as 18 percent; the local tax is deductible from taxable income. Capital gains on non-business assets are tax-exempt if held beyond a minimum span of time—the “speculation period” (e.g., six months for financial assets and two years for real estate). Furthermore there are income-specific tax allowances and deductions (e.g., a tax-free savers’ allowance for income on capital assets of DM 12,000 for married couples), and exemptions for overtime premia for work on Sundays, holidays, and at night. Unemployment benefits and social assistance income are also not taxed—though they are considered in determining the (marginal) tax rate (Progressionsvorbehalt). Pension income is taxed only to the extent that it constitutes a return on investment, which under the present tax code is calculated to be on average 27 percent of pension benefits. Income from agriculture and forestry is also treated favorably.

143. The tax code is also characterized by a large number of tax allowances. Some tax allowances adjust the tax base to better measure ability to pay more accurately—such as tax allowances for outlays necessary to produce taxable income (Werbungskosten). But even Werbungskosten allowances include tax breaks for expenses that are directly determined by the tax payer, e.g., the deduction for commuting costs is proportional to the commuting distance. Other special allowances (Sonderausgaben) are granted, for example, to defray the cost of employing domestic help.8 In the wake of unification, special depreciation allowances (Sonderabschreibungeri) expanded opportunities for tax write-offs significantly. Investment in shipbuilding and rental property also offer extensive possibilities for tax shelters. Moreover, any loss can be used to offset any other taxable income with unlimited carry forward into the future. The interplay of overly generous write-offs, unlimited loss carry forward, and tax-exempt capital gains permit substantial tax arbitrage by channeling normal—i.e., taxable—income into tax-exempt capital gains.9

144. Many of the income tax rules, primarily those motivated by special economic objectives, have severely reduced the transparency of the tax system and have made it difficult to assess the implicit subsidy component in most policy-oriented tax breaks. A number of tax rules also tend to violate both horizontal fairness (mainly due to the unequal treatment of different sources of income) and vertical tax fairness (in part because the benefits of tax breaks typically increase with the marginal tax rate).10

145. In the corporate sector, retained earnings are subject to a 45 percent corporate income tax and the local trading tax on profits. Distributed profits are taxed at a 30 percent corporate tax. However, this tax rate is mainly relevant for profit distributions to nonresidents (including foreign corporations); domestic shareholders receive a tax credit for the income tax paid by the corporation (full imputation) and are taxed according to their personal income tax rate. For businesses, tax accounting is based on commercial accounting standards, which traditionally have been liberal in Germany, since they are guided by the notion of creditor protection. As a result, accounting rules leave ample scope to build up hidden reserves in balance sheets. Losses can be carried forward indefinitely and for an unlimited amount.11 The leeway that German accounting standards provide, together with special depreciation rules for eastern Germany and increased cross-border shifting of taxation, has significantly impaired the accuracy of government estimates of revenues from corporate taxes in recent years.

146. Allowances and tax exemptions—and tax avoidance—have impaired tax collections. Large income segments are not reported to the tax authorities. Survey data for 1983 (more recent data are not available) indicate that only 64 percent of national income was declared, of which 22 percent was tax-exempt.12 As a result, barely half of national income was subject to taxation. Similar conclusions are supported by the Council of Experts (Sachverständigenrat) calculations, that indicated that just 57.4 percent of national income in 1989 was subject to taxation.13 Even prior to the special tax preferences for investment in the new Länder, the scope for tax avoidance was significant.

147. Even though the top marginal income tax rate was 56 percent in 1983, the estimated effective marginal tax rate peaked at 34 percent (at an annual income of DM 80,000) and then declined toward an effective marginal tax rate of 30 percent for higher income levels as tax breaks were exploited increasingly.14 Revenues from the assessed income tax on high-income earners and the self-employed (veranlagte Einkommensteuer) have also declined sharply. Assessed income tax revenues (adjusted for tax refunds) dropped from the equivalent of 37.3 percent of wage tax revenues (Lohnsteuer) in 1990 to 21.5 percent in 1996. While revenues from wage taxes have been stable since the 1990 Tax Reform, the yields (as percent of GDP) from the corporate income tax and the assessed income tax have fallen, (Chart IV-3). This reflects more sophisticated tax avoidance, but also the enlarged scope for tax avoidance in the wake of unification. Corporate carry-over of losses and increasing international tax shifting by corporations have likely contributed to the erosion of the corporate tax base. Moreover, there is evidence that large corporations have shifted tax liabilities abroad by booking profits in countries with lower corporate tax rates.15

CHART IV-3
CHART IV-3

GERMANY Income Taxation

(In percent of GDP)

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A004

Source: Deutsche Bundesbank and staff calculations.

C. International Comparisons and Recent Trends in German Tax Yields

148. In international comparisons, the German tax code presents a differentiated picture. In terms of personal income taxation, Germany was somewhat above the EU average for both the top marginal rate (52.5 percent) and for the effective average tax rate on labor income—calculated on macroeconomic data and actual tax receipts during the 1980s (Chart IV-4).16 The burden on labor income has, however, risen markedly in the wake of unification as the tax base related to nonwage personal income eroded further. By contrast, on the corporate side, Germany has the highest statutory income tax rate among major industrial countries, but the lowest effective average tax rate (calculated as corporate income tax as a share of the operating surplus of corporations) largely because of the liberal use of the tax breaks and relatively flexible accounting rules (Chart IV-5).17 Similarly, effective marginal tax rates on investment, which capture the tax wedge between the before and after-tax returns on a project, are relatively low by international standards, particularly compared with the United States, France, and the United Kingdom. The tax burden on consumption is also low in Germany by EU standards, which is evident in a 15 percent standard VAT rate in Germany, compared with an EU average of 20 percent.

Chart IV-4
Chart IV-4

GERMANY Statutory and Effective Average Personal Income Tax Rates

(In percent)

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A004

Sources: Price Waterhouse (1996), Deloitte and Touche (1995), Lassen and Nielsen (1996); and Ministry of Finance.1/ Includes Solidarity Surcharge (4x).2/ Effective income tax rates are the average for the period 1986–90.3/ Includes local surcharge (4x).
Chart IV-5
Chart IV-5

GERMANY Statutory and Effective Corporate Tax Rates

(In percent)

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A004

Sources: Price Waterhouse (1996), Deloitte and Touche (1995), Mendoza et al (1994).1/ Based on calculations by Mendoza et al (1994); average for the period 1984–88.

149. Mendoza, Razin, and Tesar have developed a methodological approach to assess the average tax burden on labor income, capital and corporate income, and on consumption (Chart IV-6).18 19 This approach relies on actual tax revenue and national accounts data. They compute effective average tax rates by expressing the wedge between pre- and post-tax prices and income as ratios of national accounts measures of consumption and income from labor and capital. Although this approach has some drawbacks, it effectively encapsulates international differences in tax burdens. For Germany, this approach supports other evidence that the tax burden on consumption is comparably moderate while labor income bears a relatively high tax burden. Effective average tax rates on capital and corporate incomes are low.

Chart IV-6
Chart IV-6

GERMANY Effective Average Tax Rates

(In percent)

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A004

Sources: Mendoza, Razin, arid Tesar (1994); Lassen and Nielsen (1996).1/ Data for 1989 onwards are not available.

150. The effective tax burden on consumption fluctuated in a narrow range around 15 percent of the pre-tax value of private consumption throughout the 1970s and 1980s. This tax rate placed Germany below many European countries, which was nonetheless higher than the average effective rate for the U.S. and Japan (with an average tax rate of about 5 percent). Subsequent to unification, however, the effective tax rate on consumption in Germany rose to 20 percent, but was still below the average comparable tax rate for EU countries,20 suggesting additional scope for Germany to shift taxation toward consumption.

151. As regards the taxation of labor income (including social security contributions), the effective average tax burden has displayed an upward trend in Germany as in most of the G-7 countries. After unification, the tax burden on labor income in Germany surged above 46 percent of gross compensation compared with an effective average tax rate of about 44 percent in other EU countries and less than 30 percent in the United States. In light of the evidence for almost complete tax shifting into product wages in Germany,21 the high taxation of labor has almost certainly contributed to rising labor costs.

152. The effective average tax rate on capital income presents the mirror image to that on labor income: those countries with high labor taxation, such as Germany, had the lowest effective average tax rates on capital. Throughout the 1980s, taxation on capital income declined steadily in Germany; however, unification pushed the effective average tax rate on capital back to its level of the early 1980s. Nonetheless, the tax burden on capital income in Germany (at 30 percent) remained low by the standards of G-7 countries (40-55 percent).

153. As to the effective corporate tax burden (measured as the ratio of corporate tax to the operating surplus of corporations), Germany has an effective tax rate well below the average for G-7 countries. In Germany, the effective average corporate tax rate was below 10 percent compared with about 30 percent for other G-7 countries (except for the U.K. and Japan with effective tax rates of about 50 percent). The low tax rate in Germany has been attributed in part to greater weight given to large corporations, which have more scope for avoiding taxes (e.g., by transferring tax liabilities across borders).

154. Recent research found that higher taxation, particularly in Europe on labor income, over the past two decades has led to slower growth and less employment.22 European trade unions have succeeded to a considerable extent, in shifting the burden of labor tax onto producers (unlike in the United States). The resulting higher labor costs prompted firms to substitute labor with capital and contributed to increased unemployment. Economic growth is adversely affected by reduced investment in human capital and lower marginal productivity of physical capital. Based on econometric estimates, the rise in effective average labor taxes of 8 percentage points experienced by Germany between 1965-75 and 1976-91 would have reduced per-capita GDP growth by 0.4 percentage points per annum and contributed 3-5 percentage points to the unemployment rate. This evidence therefore suggests that even though a higher tax burden on labor income (as the less mobile factor) may be consistent with taxation theory, it might, nonetheless, have adverse effects on the tax yield, real growth, and employment.

155. While effective average tax rates can only approximate marginal tax rates that matter for economic decisions, a methodological technique developed by King and Fullerton23 estimates the marginal tax burden on income from new investment.24 This approach seeks to combine corporate and personal income taxation and other features of the tax code, such as depreciation allowances, to estimate the effective tax wedge between the pre-tax return on an investment project and the after-tax return received by the ultimate investor. The results suggest that the marginal tax burden on income from investment is low in Germany relative to G-7 countries.

156. This approach also highlights the tax treatments of various types of investment (primarily machinery versus construction) and of different financing modes (e.g., retained earnings, debt, and equity). The combined effective marginal tax rates on investment (inclusive of corporate and personal income taxes) in Germany declined in the 1980s by about 10 percentage points to 32 percent, which was the lowest tax rate among the countries studied (United States, United Kingdom, and France) (Table IV-1).25 26 Notwithstanding the decline in the overall marginal effective tax rate on investment in Germany, the difference between the effective marginal tax rate on debt-financed investments and those financed by retained earnings widened during the 1980s. Leibfritz,27 however, suggested that this difference narrowed subsequently in the wake of the 1990 tax reform, which reduced marginal income tax rates. Nonetheless, investment financed by retained earnings incurred the highest effective marginal tax rates compared with new equity, while debt-financed investment had the lowest tax rates.28

Table IV-1.

Germany: Marginal Effective Tax Rates

(In percent)

article image
Source: Jorgenson and Landau (1993).

D. The Government’s Tax Reform Proposals

157. The Government’s tax reform plan aims to correct many of the above mentioned weaknesses in the tax system and to shore up Germany’s global tax position.29 (It is intended to become effective largely in 1999.) To improve investment incentives and bolster Germany as a location for production (Standort Deutschland), marginal personal and corporate income tax rates would be reduced. The top personal marginal rate would be lowered from 53 percent to 39 percent, while the entry marginal rate would be reduced from 25.9 percent to 15 percent (see Chart IV-2). The solidarity surcharge would also be cut in 1998 from 7.5 percent of income taxes to 5.5 percent. The maximum marginal rate on business income would drop in two steps from 47 percent to 40 percent in 1998 and to 35 percent in 1999. The top marginal tax rate on retained profits would be lowered from 45 percent to 40 percent in 1998 and to 35 percent in 1999. The marginal corporate tax rate would be reduced in two steps from 30 percent to 28 percent in 1998 and to 25 percent in 1999.

158. At present, interest paid to German residents is subject to a withholding tax of 30 percent on registered transactions and 35 percent on over-the-counter transactions (Tafelgeschäfte).30 These withholding tax rates would be lowered to 25 percent and 30 percent, respectively. Dividend income on German residents is subject to a withholding tax of 17.5 percent plus a corporate income tax of 30 percent, or 47.5 percent in total. This total tax rate is below the top marginal income tax rate. (Germany applies full imputation for dividend taxation by crediting to the shareholder in full the amount of tax paid by the corporation.) Under the tax reform proposal, the dividend withholding tax would be reduced to 11.25 percent and the corporate income tax to 25 percent (or to a total marginal rate of 36.25 percent). This lower combined marginal tax rate would be close to the proposed top marginal personal income tax rate of 39 percent.

159. The lower marginal tax rates on personal income would reduce economic distortions and the incentives for tax avoidance. At the lower end of the tax schedule, unemployment traps would be lessened, but they would remain considerable owing to the withdrawal of assistance.31 Therefore scope remains for closer coordination of taxation with the system of social assistance.32

160. The proposals to broaden the personal income tax base are significant steps toward making the tax code fairer and more consistent. The tax base would be broadened by subjecting previously tax-exempt types of income to taxation (see text box).33 This reduction of tax breaks affects both private households and firms. For private households, tax base broadening would be accomplished by phasing in the full taxation of certain premium time bonus pay such as for work on Sundays, holidays, and at night and for mining work, and of certain fringe benefits such as severance pay and anniversary bonuses. The share of public pension incomes subject to taxation would be raised from an average of 27 percent to 50 percent.34 The standard deduction for expenses connected with income from dependent work would be reduced from DM 2,000 to DM 1,300 and the deduction for commuting distance would be scaled back. The savers’ tax-free allowance for interest income would be halved to DM 3,000 for a single tax payer and DM 6,000 for a married couple.

Main Proposals on Income Tax Reform

The Government’s proposals on tax reform described below were passed by the Bundestag in June 1997. But the legislation was vetoed by the Bundesrat in July 1997 and the reconciliation committee failed to reach a compromise in late July.

Reductions in Tax Rates

• The top marginal rate on personal income would be reduced from 53 percent (for incomes above DM 120,000; single tax payer) to 39 percent (for incomes above DM 90,000), and the entry rate would be lowered from 25.9 percent to 15 percent;

• the flat entry rate of 15 percent for incomes between DM 13,014 and DM 18,035 (single tax payer) would be followed by a linear-progressive (continuous) tax schedule rising from a rate of 22.5 percent to 39 percent;

• the personal income tax rate on business income would be reduced from 47 percent to 35 percent;

• the withholding tax rate on interest income would be cut from 30 percent to 25 percent;

• the corporate tax rate on retained profits would be lowered from 45 percent to 35 percent, and the tax rate on distributed profits (which is fully applied to a shareholder’s tax liability on dividend income) would be reduced from 30 percent to 25 percent.

Extensions of the Tax Base

Subjecting a Wider Range of Income to Taxation

• frill taxation of bonuses for work on Sundays, holidays and at night, and some employer paid fringe benefits would be phased in until 2003;

• half of the retirement income from public pension schemes would be taxable (compared with about 27 percent under current rules);

• instead of taxing extraordinary income at half the regular tax rate, such income would be distributed over up to 7 years;

• capital gains on personal assets would remain exempt from taxation, but the “speculation period” during which they are subject to tax would be extended to one year (from six months) for financial assets and to 5 years (from 2 years) for real estate.

Reducing Deductions and Tax Allowances

• the standard allowance for income-related expenses and special deductions for commuting distance would be reduced;

• the savers’ tax-free allowance would be halved to DM 3,000 for a single tax payer and DM 6,000 for married couples filing jointly;

• the accelerated depreciation rate for machinery and equipment would be lowered by 5 percentage points;

• the depreciation rate for commercial buildings would be reduced from 4 percent to 3 percent per annum; and the accelerated depreciation on rental housing would be eliminated.

Tightening of Corporate Accounting Rules

• accounting rules related to retaining hidden reserves and to risk provisions for pending transactions would be tightened;

• loss carry-forward would be restricted to half of the profits in any given year;

• some (but not all) tax concessions for agriculture and shipping would be eliminated.

Measures to be Implemented in 1998 Ahead of the 1999 Reform

• the solidarity surcharge would be cut from 7.5 percent to 5.5 percent of the income tax liability;

• the top personal tax rate on business income would be reduced from 47 percent to 40 percent;

• the corporate tax rate on retained profits would be cut from 45 percent to 40 percent and on distributed profits from 30 percent to 28 percent;

• corporate accounting rules would be tightened to make the above measures broadly revenue neutral;

• the local trading tax on capital would be abolished.

161. For enterprises, under German tax law commercial and tax accounting go hand in hand—the so called linkage principle. Although this principle would not be abolished, it has been proposed that tax accounting should differ from commercial accounting to improve the assessment of profits by preventing the creation of substantial hidden reserves in the balance sheet. For example, under existing accounting rules, a business that has made an extraordinary write-down can maintain its lower book value even after the reason for the write-down no longer pertains. The tax savings are thus preserved indefinitely. It has been proposed to introduce a mandatory write-up, or appreciation, to the higher of fair market value or production costs, if the reason for the extraordinary depreciation no longer applies. The rules for setting-aside provisions for risks from pending business transactions would also be tightened.

162. The accelerated (declining balance) depreciation allowance on equipment investment would be reduced from 30 percent to 25 percent of the residual value. The linear depreciation on commercial buildings would be lowered from 4 percent to 3 percent per annum, and the accelerated depreciation on rental housing and the special depreciation for buildings in urban development areas would be abolished. In addition, capital gains rules would be made more restrictive: the rollover or reinvestment of capital gains would be limited to land and buildings; the tax-free allowance (maximum of DM 60,000) in case of the sale of a business would be abolished; and the special startup depreciation and tax-free reserves for small and medium-sized enterprises would be abolished even though they had just been extended by the 1997 Tax Act. These changes would make many existing tax shelters unattractive.

163. The tax reform proposals constitute an important step toward moving to a comprehensive income tax base and eliminating some big tax shelters. The proposals represent progress toward the reduction of distortions of tax-favored activities, as a number of preferential tax rules (though not all) for agriculture and shipping would be eliminated, while depreciation rates for buildings and land would be scaled back. They would thus restrict the opportunities for tax arbitrage and minimize the distortions of investment. The proposed reduction in corporate tax rates in combination with fewer investment incentives and a more transparent determination of profits would likely have positive effects on the allocation of capital because investment decisions would thus be based more on economic fundamentals than tax considerations. The broader tax base would also alleviate concerns about horizontal equity and—in combination with lower marginal tax rates—would help to simplify the income tax code both directly and through smaller incentives for complicated tax avoidance schemes. This would make the effects of the tax rules more transparent.

164. The tax reform proposals would be a step toward rebalancing the tax structure. The shift from direct to indirect taxes, which tend to be less distortionary, would strengthen incentives for investment, work, and eventually growth. Increasing VAT would also align Germany’s tax structure with that of other European countries. The Government has also proposed to abolish the local trading tax on capital—one of the key taxes for municipalities with a tax yield of about DM 5 billion.35 This tax is levied on a company’s equity and long-term debt. Since the tax liability is independent of profitability, it can diminish the financial capacity and liquidity of a firm. At the margin, the elimination of the capital tax would benefit firms in western Germany, since the tax has so far not been imposed on firms in eastern Germany. But the EU has formally approved this exception only until temporarily. Thus, if the tax were not be eliminated, it would have to be extended to the new Länder in 1998.

165. The proposed tax reform plan is, however, less ambitious than other proposals for tax reform, such as the Bareis Commission,36 which was appointed by Finance Minister Waigel in 1993, and the plan proposed in 1995 by Mr. Uldall, a leading member of the business group of the CDU’s parliamentary group.37 The Bareis Commission envisaged raising DM 35 billion from a broadening of the personal income tax base alone. By contrast, only about DM 14 billion would be raised under the current reform plan from a broadening of the personal income tax base. Most of the base broadening would take place with respect to the corporate income tax base with about half derived from revised accounting rules.

166. The new proposals leave unaddressed some weaknesses in the tax code. While some proposals of the Bareis Commission, such as the abolition of various tax breaks and in principle the adherence to a linear progressive income tax schedule, have been incorporated in the proposed tax reform, this reform does not fully correct some systematic abnormalities and does not eliminate all tax breaks. It maintains, for example, tax advantages for shipbuilding, merchant shipping, and agriculture. Similarly, it does not systematically revise tax allowances for expenses that are determined by the tax payer (e.g., for offices at home, company cars, and a second household), as suggested by the Bareis Commission. The reform plan merely envisages a cut and modest revision in the commuter tax allowance.

167. The proposals do not completely adopt the principle of equal treatment of all forms of income. Even after the reform, various types of income would be taxed differently and some tax allowances for specific income sources would be retained. A faster phasing in of the taxation of bonuses for work on Sundays, holidays, and at night would be preferable. Similarly, the partial taxation of unemployment benefits and other income replacement payments, which was struck out by the Bundestag, would be a reasonable measure to promote more uniform taxation of income. Moreover, the differential tax treatment of personal and business incomes (and of capital gains) would leave in place the incentive for income shifting to lessen the tax burden.

168. A more systematic tax treatment of pension income is also absent. Instead of raising the share of pension income subject to taxation rather arbitrarily to 50 percent, a more systematic approach would make all pension contributions tax-exempt and, in turn, tax pension income as ordinary income (in line with the so-called correspondence principle). The correspondence principle should also be applied to the private provisioning for pension income, which will gain importance in the future (see chapter V on pension reform), by making contributions tax-exempt but future income taxable.

169. The tax reform proposals are not explicitly set in an international, and in particular a European context. The proposed reform would lower the tax on profits paid to foreign parent companies. For German parent companies of foreign subsidiaries, the tax reform does not consider introducing a credit for foreign-paid corporate income tax to avoid double taxation (which applies for example in the United States and the United Kingdom). Moreover, while the tax reform lowers the withholding tax rate on interest income, it is silent on a broader “European” approach that would reduce the problem of tax evasion on interest income.

170. One key element of a more far-reaching reform—but which also would be most controversial—is the taxation of capital gains on personal assets.38 There are valid considerations that would argue against introducing such a capital gains tax. It would likely be administratively cumbersome (e.g., for the valuation of real estate), might have to allow the deduction of capital losses and, according to Ministry of Finance calculations, would yield relatively little from limited private financial assets. Some observers are concerned that a tax on capital gains may undermine the promotion of Germany as a financial center. However a capital gains tax would be desirable not only from a tax system point of view, but also because the absence of a tax on capital gains still leaves open one of the biggest tax loopholes. The sheltering of taxable income by shifting it toward eligible capital gains is highly regressive and would continue, albeit to a lesser extent as lower marginal tax rates would reduce the incentive for such shifting. As a result of the special depreciation rules in the new Länder, tax-free capital gains have been a particular boon for high-income real estate investors and have been one of the key factors behind the shrinking tax base on personal nonwage income.

E. The Effects of the Tax Reform Proposals

171. The proposed cut in tax rates on personal and corporate income would reduce gross revenues by DM 87.5 billion (Table IV-2).39 This reduction would be partly offset by additional revenues from a broader tax base, amounting to DM 42.6 billion. The resulting financing gap of some DM 44.9 billion would be partially closed by as yet unspecified increases in indirect taxes of DM 14 billion. (This amount could be raised, for example, by a 1 percentage point increase in the VAT rate.) The proposed net tax relief, which includes the 2 percentage point reduction in the solidarity surcharge planned for 1998, would amount to about DM 30.9 billion or ¾ percent of GDP by 1999.

Table IV-2.

Germany: Revenue Effects of the Tax Reform Acts Passed by the Bundestag

(In billions of deutsche mark)

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Source: Aktuelle Beiträge zur Wirtschafts- und Finanzpolitik (June 26, 1997), Press Office of the Federal Government.

Not yet proposed to the Bundestag.

172. Official calculations of the distribution of the tax relief indicate that the business sector (including agriculture and forestry) would obtain 34.2 percent of the benefits from the reduction in tax rates, while contributing 45.6 percent to the broadening of the tax base (Table IV-3).40 Correspondingly, the personal sector would reap 65.8 percent of the benefits from lower tax rates and account for 54.4 percent of the tax base broadening. Total net tax relief for the business sector in 1999 has been officially estimated at about DM 6 billion (or one sixth of the total tax relief). Lower tax rates would yield a tax relief of DM 6 billion, which would be more than offset by measures to broaden the tax base of DM 12 billion. The higher tax on business would largely finance the proposed reduction in the solidarity surcharge (DM 7 billion).

Table IV-3.

Germany: Distribution of Tax Relief of the Proposed Tax Reform 1/

(In billions of deutsche mark)

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Source: Ministry of Finance.

Based on the Waigel Commission proposals.

Including agriculture and forestry.

173. Estimates by the Deutsches Institut für Wirtschaftsforschung (DIW) paint a somewhat different picture of the distribution of tax relief. According to DIW calculations, 57 percent of the net tax relief would accrue to profit taxation, while 43 percent would reduce wage taxation (Table IV-4).41 Thus, DIW contends that the decline in the taxation of profits (entrepreneurial and property income), which has proceeded steadily since the early 1980s, would continue.42 Based on these estimates, wage taxes would fall by 1¼ percent of gross wages and salaries, and the effective average tax burden on labor income would decline by 1 percentage point. But the personal income tax reduction as a function of income levels is u-shaped; i.e., tax reductions (in percentage terms) are larger in the upper and lower income brackets than for upper-middle income earners.43 Overall, DIW’s wage tax model indicates for west Germany that the top 10 percent of wage earners would receive about 35 percent of the total tax relief. Half of the tax relief would accrue to the top 20 percent of wage earners. This analysis, however, takes only limited account of the planned abolition of, or reductions in, tax allowances. It may thus overstate the tax reductions particularly for upper income tax payers.

Table IV-4.

Germany: Revenue Effects of the Proposed Tax Reform 1/

(In millions of deutsche mark)

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Source: DIW Wochenbericht 15/1997.

Based on the Waigel Commission proposals.

174. To judge the impact on investment decisions and to assess the net effect on the tax burden stemming from the simultaneous cut in corporate (and personal) tax rates and the diminished depreciation allowances, marginal effective tax rates on investment were calculated by the staff along the lines described in OECD.44 45 These effective tax rates are designed to capture the wedge created by taxation between the pre-tax rate of return required from the corporation’s point of view to implement an investment project and the post-tax return received by the ultimate saver/investor. They are also intended to take into account—in addition to statutory corporate and personal tax rates—other aspects of the tax code that affect investment decisions, foremost among them being the depreciation rules (Table IV-5).46 Effective tax rates in general also require consideration of personal tax rates and whether these are integrated with corporate taxation (e.g. through full imputation of dividend taxation such as in Germany).

Table IV-5.

Germany: Parameters for the Calculation of Effective Marginal Corporate Tax Rates

(In percent)

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175. The results indicate that the proposed tax measures would lower the overall effective marginal tax burden on corporate investment. The marginal tax reductions (in percentage terms) would be slightly smaller for investment in machinery and equipment (8.5 percentage points) than for investment in buildings (10.2 percentage points) (Tables IV-6 and IV-7). With personal taxes included, the difference in the effective tax rate on buildings and on machinery would remain broadly unchanged, although the scaling back of depreciation allowances would tend to have a larger adverse effect on corporate building investment. The overall effective tax rate drops by 9.8 percentage points inclusive of personal taxes and by 10.7 percentage points based exclusively on corporate taxation.

Table IV-6.

Germany: Effective Marginal Tax on Investment Under the Current Tax Code

(Tax wedge 1/; tax rate 2/)

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Source: Staff calculations.

Difference (in percentage points) between required pre-tax rate of return and after-tax rate of return received by investor.

Tax wedge as a percent of required pre-tax rate of return (shown in parantheses).

Table IV-7.

Germany: Effective Marginal Tax On Investment Under the Government’s Tax Reform Proposal

(Tax wedge 1/; tax rate 2/)

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Source: Staff calculations.

Difference (in percentage points) between required pre-tax rate of return and after-tax rate of return received by investor.

Tax wedge as a percent of required pre-tax rate of return (shown in parantheses).

176. The proposed tax reform would lessen the tax-induced distortions related to the modes of financing, as it would substantially narrow the differences in effective marginal tax rates across forms of financing. The taxation of equity and internally financed investments would be lowered, while the tax advantage of debt financing would decline markedly owing to the reduction in corporate and personal income tax rates. Retained earnings are the most heavily taxed (at the margin) mode of financing, followed by new equity issues. These relative rankings would not be changed by the proposed tax measures, but equity financing would become more attractive relative to the other modes of financing.

177. Because accounting provisions that facilitate the build-up of hidden reserves would be tightened as part of the tax reform (e.g., through a write-up requirement if the earlier special depreciations have become obsolete), the costs of internal financing would increase slightly. The clear tax advantage of debt-financing (based on these calculations) would remain—though it would be markedly reduced. The improved relative standing of new equity financing could help broaden the traditionally narrow German equity markets.

178. For an average firm in manufacturing, the Center for European Economic Research (ZEW) arrived at a similar assessment.47 It calculated that under the proposed tax reform the effective tax burden of an average manufacturing enterprise would decline from about 40.2 percent to 34.7 percent.48 However, even at the proposed lower tax rate, the effective tax burden in Germany would still exceed the effective tax burdens in the United Kingdom (23.1 percent), Netherlands (26.1 percent), and the United States (31.2 percent), but would fall below the effective tax rate in France (38.7 percent). The ZEW data indicate that further reductions in the tax burden in the manufacturing sector could be needed.

179. The overall macroeconomic effects of the proposed tax reforms depend on the extent the net income tax relief would translate—ceteris paribus—into lower labor costs and how the financing gap of % percent of GDP would be financed. Any estimates of the impact would thus be tentative. Moreover, the positive effect of tax reform could be strengthened if it were complemented by structural measures aimed at more flexibility in the labor market. Two economic institutes, DIW and the Rheinisch-Westfälisches Institut für Wirtschaftsforschung (RWI), have undertaken various scenarios of the macroeconomic effects of tax reform. These scenarios differ according to whether the tax reform is financed by a higher deficit or by lower expenditures.49 50 The DIW estimates ranged from a 1¼ percent higher GDP after four years (and an employment increase of ½ percent) based on deficit financing to ¾ percent lower GDP (and an employment decrease of ½ percent) assuming an uncharged fiscal deficit. In contrast, calculation using estimates by Leibfritz, et al. indicate that tax cuts, particularly on labor and capital income, can boost economic activity and employment markedly, even if they are fully offset by spending cuts.51 Since consumption taxes typically are less distortionary, a shift from labor taxation to consumption taxation is also estimated to raise both output and employment. Applied to the proposed tax reform, these calculations would suggest that over the long term, GDP would rise by 2½ percent while employment would grow by 1¼ percent.52 As lower wage taxes would reduce labor costs and support the shift toward lowering the capital labor ratio, the higher marginal productivity of capital would stimulate the accumulation of capital and economic growth.53

180. The implied decline in the marginal tax rates on investment suggests that the impact on total investment of the proposed tax reform is likely positive. The expansionary effect on business investment should, however, not be overstated. The proposed measures would imply a relative shift of the tax burden to new investment: while all (profitable) enterprises would benefit from the rate cuts, the less generous depreciation allowances apply only for new investment. Some sectors, where investment is particularly sensitive to tax considerations (such as the housing sector), would in fact be adversely affected by the proposed tax changes.

181. The effects of the reform proposals are thus unevenly distributed across sectors and depend on the composition of the firms’ capital stock and cyclical sensitivity. Investment-intensive enterprises that invest heavily in machinery and equipment and thus have relatively short-lived capital stocks would be particularly adversely affected by the broadening of the corporate tax base. Enterprises in the service sector would, by contrast, benefit primarily from the reduction in corporate tax rates without marked effects from tighter depreciation rules. Moreover, the introduction of mandatory write-up rules would adversely effect companies that have large reserves on their balance sheets, which tend to be capital-intensive firms. The curtailment of loss carry forward provisions would adversely affect cyclical sensitive industries, such as steel and automobiles. Moreover, firms would benefit from the reduction in tax rates proportionately to their profitability, implying significant differential effects across sectors.

182. One of the hardest hit sectors would be new rental housing, since tax breaks are most concentrated in that sector.54 Rental units held as personal property would be adversely affected by the impact of lower income tax rates, which reduces the investment incentive for high-income earners, and the broadening of the tax base eliminates favored treatments such as accelerated depreciation and short holding periods to qualify for tax exempt capital gains. The elimination of the accelerated depreciation could lead to liquidity problems in the early years of a typical new rental housing project. Rental housing is expected to become a less attractive investment opportunity for private investors, while institutional investors (such as insurance companies) and residential real estate companies would be affected less by some of the proposed tax changes.55 Overall, the withdrawal of tax breaks for rental housing could boost owner-occupied housing. Moreover, since tax-induced investments would diminish, economic fundamentals would gain in importance for investment decisions. Consequently, the housing market might become more efficient and the volatility in residential housing—in part created by tax-induced pro-cyclical decisions by private investors—might decline to the extent that commercial and institutional investors would come to dominate.56

183. The overall impact of the tax reform (and the proposed elimination of the local trading capital tax in western Germany) would be a diminution of the present tax advantages enjoyed by east over west Germany. The impact on investment in eastern Germany could be adverse and larger than the impact on investment in west Germany.57 Despite chronically low profitability, the scaling back of tax breaks and lowering of marginal tax rates would affect economic activity in east Germany relatively more than in west Germany. This differential impact occurs because investment comprises a larger share of economic activity in east Germany than in west Germany and because tax concessions are relatively more heavily utilized to support investment in east Germany. In addition, lower corporate tax rates would improve the financial position of firms in west Germany more than in east Germany, because on average firms are less profitable in east Germany.

184. As to the attractiveness of Germany as a location for foreign direct investment, the proposed tax reform—though lowering the tax on distributed profits to foreign parent companies—would not markedly correct the tax disadvantage compared with other European countries. The reduction of the corporate tax rate on distributed profits would reduce the total tax rate on profits paid to a foreign parent company from 47.7 percent to 42.7 percent in 1999.

185. (Table IV-8).58 But even at that level, Germany would only move down one place in its European ranking (Chart IV-7). Nonetheless the headline statutory tax rate on retained profits, which draws much attention in international comparisons, would be reduced by 10 percentage points. However, given the opportunities of multinational corporations to shift tax liabilities abroad, the role of corporate taxation in decisions on production locations might be losing its significance.

Table IV-8.

Germany: Taxation of Distributed Profits to Foreign Parent Companies Under the Government’s Tax Reform Proposal

(In percent)

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Source: American Chamber of Commerce in Germany, 1997.
Chart IV-7
Chart IV-7

GERMANY Tax Rates on Distributed Profits to U.S. Parent Company

(In percent)

Citation: IMF Staff Country Reports 1997, 101; 10.5089/9781451810318.002.A004

Source: American Chamber of Commerce in Germany (1997).1/ Under current tax law.2/ After proposed tax reform.

186. The impact on private consumption of the proposed net tax relief could be substantial. Abstracting from increases in consumption taxes, low income households with higher marginal propensities to consume could benefit from tax reform. They would gain from the lower entry marginal income tax rates and less progressive linear tax schedule, while they are relatively unaffected by the closing of tax loopholes. The net tax relief accruing to high-income earners would have less impact on consumption owing to their higher marginal propensity to save. A full assessment on consumption behavior is hampered, however, by the uncertainty about the long-term financing of the net tax relief.

187. The impact on employment depends on the flexibility of the labor market (in particular on the relative response of consumption wages and production wages) and on the elasticities of the labor supply and demand. The smaller income tax wedge could lead to diminished demands for gross wages and thus lower firms’ wage costs (production wages). Alternatively, trade unions may bargain to retain the net tax relief for workers. Thus net wages would increase one-for-one with the tax cut with no reduction in labor costs. The effect on gross wages (and labor costs) may also be limited by the relatively small elasticity of the labor supply typically estimated in Germany.59 Studies suggest that the only group that would increase its labor supply in response to lower marginal tax rates would be married women. As the tax reform would reverse some—albeit a relatively small part—of the increased tax burden on labor income that occurred during the past decade, the positive effects would be bolstered by structural measures aimed at more flexible wage setting and open labor markets.

ANNEX I: Effective Average Tax Rates Based on Macroeconomic Data

188. Mendoza, Razin, and Tesar compute effective average tax rates using national accounts and actual tax revenue data.60 61 These effective tax rates are consistent with the tax rates faced by a representative agent in a general equilibrium setup. The numerators measure the difference between the before-tax and after-tax values of consumption, labor income, and capital income, approximated by the tax revenue collected from each tax. The tax bases in the denomerators measure consumption, labor income, and capital income at before-tax prices.

Effective average tax rate on consumption

189. The effective average tax rate on consumption, τc, is calculated as the ratio of revenues from indirect taxation (general taxes on goods and services, tg, and excise taxes, tc) relative to the before-tax value of consumption as the tax base,

τc=[(tg+te)/(C+G−Gw−tg−te)]

where the part of public consumption that is typically subject to indirect taxes excludes compensation of government employees, Gw.

Effective average tax rate on labor income

190. The effective tax rate on labor income, τ1, is derived in two steps, under the assumption that all sources of household income are taxed at the same rate. First, the average tax rate on total household income, τh, is calculated as the ratio of household income tax revenue, th, as a percent of the sum of wage income, W, households’ property and entrepreneurial income, Ph, and the operating surplus of unincorporated businesses, OSu.

τh=th/[W+Ph+OSu]

191. Second, the effective average tax rate on labor income combines the estimated tax on wages and salaries, τhW, with social security contributions, ts, and other payroll taxes, tP, and expresses it as a ratio to gross income from dependent employment (i.e.; the sum of wages and salaries, W, plus employer-paid social security contributions, SE).

τl=[τhW+ts+tp]/[W+SE]

Effective average tax rate on capital income

192. The effective average tax rate on capital income, τk, is defined as the ratio of capital income taxes to the total operating surplus in the economy, OS.

τk=[τh(OSu+Ph)+tcorp+tprop+tfin]/OS

Capital income taxes in the numerator are the sum of the estimated capital income tax paid by households, τh(OSu + Ph), the corporate income tax, tcorp property taxes, tprop, and taxes on financial transactions, tfin.

ANNEX II: Marginal Effective Tax Rates on Investment

193. The calculations of marginal effective tax rates on investment closely followed accepted methodology.62 Corporate and personal income taxes drive a wedge between the before-corporate tax rate of return, p, on an investment project and the after-tax return, s, that an individual investor receives. Consider an investment project with a depreciation rate of δ and a perpetual rate of return, r. The before-tax net rate of return is therefore p=r-δ. Denote the present value of depreciation allowances and other tax incentives by A. For a marginal investment project, in equilibrium the net cost of the project (1-A) is equal to the present value of the discounted future after-tax cash flow,

(1−A)=[(1−τ)(p+δ)/(ρ+δ−π)]

where τ is the corporate income tax rate, ρ is the discount factor, and π is the rate of inflation. Solving for the before-tax rate of return, p, yields

p=[(1−A)/(1−τ)](ρ+δ−π)−δ.

194. Suppose an investor can earn a nominal interest rate, i, on an alternative investment, subject to a personal income tax rate, m. Then the real after-tax return, s, on the alternative investment is

s=(1−m)i−π.

195. The marginal effective tax rate, t, on income from the investment project is defined as the ratio of the tax wedge (between the before-tax return on the investment, p, and the after-tax return for the investor, s) and the before-tax return, p,

t=(p−s)/p.

196. In the absence of any taxes (and assuming investors are risk neutral), the factor used to discount the project’s cash flow would be equal to the rate of return in the capital market, i. However, if corporate and personal income taxation differentiates between interest payments, capital gains, and distributed profits, the effective discount rate depends on how the investment project is financed. For debt financing, the appropriate discount rate is ρ=(1 - τ)i, because interest payments are tax deductible for the corporation. For new equity issues, the discount rate is ρ = i/0, where θ captures the different tax rates on retained earnings and distributed profits. In the German case, with full imputation θ = 1/(1 - τ), and thus ρ = (1 - τ)i. For retained earnings, the discount rate is ρ = (1 - m)i.

1

Prepared by Burkhard Drees and Wolfgang Merz.

2

Including the solidarity surcharge on income tax, which would be cut by 2 percentage points, the top income tax rate would drop from 57 percent to 41 percent.

3

The opposition SPD’s income tax reform plan, which was released in May 1997, envisaged tax relief of Vi percent of GDP. It would fully offset an increase in the basic personal income tax allowance, a lower entry rate on personal income (with the top marginal tax rate kept unchanged), and a reduced tax rate on retained corporate earnings by broadening the corporate tax base and by a hew wealth tax on personal assets. The SPD has also proposed to lower social security contributions by 2 percentage points (equivalent to ¾ percent of GDP) financed by higher VAT and mineral oil taxes (½ percent of GDP). An increase in child benefits would be financed by a special program to combat tax evasion.

4

For an analysis of the 1998 U.S. tax reform, see A. J. Auerbach and J. Slemrod, “The Economic Effects of the Tax Reform Act of 1986”, Journal of Economic Literature, XXXV (June 1997), pp. 589-632.

5

The narrowing of the tax base has been in part due to tax incentives designed to benefit the new Länder. Reform of these tax measures was not within the terms of reference of the Waigel Commission. The Government intends to replace numerous special depreciation allowances by direct investment grants from 1998 onward.

6

For an outline of the reforms; see L. Lipschitz, J. Kremers, T. Mayer, and D. McDonald, The Federal Republic of Germany: Adjustment in a Surplus Country, IMF Occasional Paper No. 64, January 1989 (Washington: International Monetary Fund).

7

Since 1995, a solidarity surcharge of 7.5 percent of the income tax liability has been imposed.

8

In the 1997 Tax Act, the maximum deduction from taxable income for expenses in connection with employment of domestic help was raised from DM 12,000 to DM 18,000.

9

As an example, heavily debt-financed real estate investments may record tax losses, which can be deducted from taxable income, due to their financing costs and an annual depreciation allowance of 5 percent during the first seven years. In addition, if the property is later sold, the capital gains are tax-exempt.

10

Horizontal fairness treats taxpayers with similar incomes in a comparable way, while vertical fairness treats taxpayers according to their ability to pay.

11

Losses of up to DM 10 million can be carried backward a maximum of two years. A huge overhang of potential corporate loss carry-overs exists—official estimates were more than DM 200 billion in 1997—that can be used at any time to reduce tax liabilities.

12

O. Lang, K.-H. Nöhrbass, and K. Stahl, “On Income Tax Avoidance: The Case of Germany”, ZEW Discussion Paper No. 93-05, March 1993 (Mannheim: Zentrum fur Europäische Wirtschaftsforschung). This study was based on the 1983 German Income and Consumption Survey.

13

See Council of Economic Experts, Im Standortwettbewerb, Annual Report 1995 (Stuttgart: Sachverständigenrat), p. 203.

14

Lang et al., “On Income Tax Avoidance”.

15

The 20 largest listed companies in Germany have reduced their effective tax rate by 11 percentage points since 1991, partly by shifting the taxation of profits abroad; see German Brief, 5/2/97, published by the Frankfurter Allgemeine Zeitung GmbH Information Services.

16

In Chart IV-4, the data on statutory tax rates are from Price Waterhouse, “Individual Taxes: A Worldwide Summary,” (New York, 8/1996), and Deloitte Touche, “Taxation in Western Europe,” (New York, October 1996).

17

In Chart IV-5, data on statutory tax rates are from Price Waterhouse, “Corporate Taxes: A Worldwide Summary,” (New York, 8/1996), and Deloitte Touche, “Corporate and Withholding Tax Rates Between Major Trading Nations,” (New York, April 1995).

18

E. G. Mendoza, A. Razin, and L. L. Tesar, “Effective Tax Rates in Macroeconomics: Cross-country Estimates of Tax Rates on Factor Incomes and Consumption,” Journal of Monetary Economics, Vol. 34, 1994, pp. 297-323.

19

This method is briefly described in annex I of this chapter.

20

D. D. Lassen and S. B. Nielsen, “Is the Tax Burden in Denmark Higher than in Other European Countries?” Nationaløeconomisk Tidsskrift, Vol. 134, 1996, pp. 209-222.

21

T. Tyrväinen, “Wage Determination in the Long Run, Real Wage Resistance and Unemployment: Multivariate Analysis of Cointegrating Relations in 10 OECD Countries,” Discussion Paper, December 1995 (Helsinki: Bank of Finland).

22

W. Leibfritz, J. Thornton, and A. Bibbee, “Taxation and Economic Performance,” Economics Department Working Paper No. 176, (Paris: OECD), 1997, and F. Daveri and G. Tabellini, “Unemployment, Growth and Taxation in Industrial Countries,” unpublished, 1997.

23

M. A. King and D. Fullerton, eds., The Taxation of Income from Capital: A Comparative Study of the United States, United Kingdom, Sweden, and West Germany (Chicago: University of Chicago Press, 1984).

24

The King-Fullerton approach is briefly outlined in annex II.

25

D.W. Jorgenson and R. Landau, eds., Tax Reform and the Cost of Capital: An International Comparison, (Washington: The Brookings Institution, 1993).

26

A similar picture emerges based on corporate tax rates alone.

27

W. Leibfritz, “Germany” in Tax Reform and the Cost of Capital: An International Comparison, ed. by Dale W. Jorgenson and Ralph Landau, (Washington: The Brookings Institution), 1993.

28

These results could be considered a paradox since more than three-quarters of investment in Germany is typically financed by internally generated funds (J.S.S. Edwards and K. Fischer, “Banks, Finance, and Investment in West Germany since 1970”, Discussion Paper No. 497, ed. by Center for Economic Policy Research, (London), January 1991). However, the methodology used to estimate effective marginal tax rates does not incorporate the effects of accounting rules (except depreciation allowances). German accounting rules afford relatively wide discretion in valuing assets and are geared toward the protection of creditors. As a result, profits tend to be understated and sizable hidden reserves are routinely built up in corporate balance sheets. The implied tax saving effects for internal financing that stem from hidden reserves are not included in the calculations of effective marginal tax rates.

29

Press Office of the Federal Government, “Steuerreform”, Aktuelle Beiträge zur Wirtschaftsund Finanzpolitik, No. 13/1997, 6/26/1997.

30

Individuals can claim a saver’s tax-free allowances of currently DM 6,000 for a single tax payer; this allowance is proposed to be halved in 1999.

31

C. Thimann, “Effective Taxation for Recipients of Social Assistance in Germany and the Consequences of the 1996 Tax Reform”, IMF Working Paper 95/120, November 1995 (Washington: International Monetary Fund).

32

The Commission on Alternative Tax-Transfer Systems recommended, inter alia, that the income calculations that determine social benefits be aligned with the income calculations for income taxation purposes, and that the share of wage income that counts toward social assistance benefits be reduced; Commission on Alternative Tax-Transfer Systems, “Integration of Income Taxation with Tax Financed Social Benefits”, Schriftenreihe, Heft 59, ed. by Ministry of Finance (Bonn), June 1996.

33

The Government had proposed some measures to broaden the tax base which subsequently were changed during the deliberations in the Bundestag. For example, the Government proposed to subject bonus pay for work on Sundays, Holidays and at night to full taxation starting in 1999, whereas the Bundestag opted to phase out these exemptions over four years. In addition, the Bundestag eliminated the proposal to tax half of unemployment benefits, short-time work compensation and bad weather pay, which are presently completely exempt.

34

Currently only that part of public pensions that represents a (fictitious) return on investment (Ertragsanteil) (about 27 percent on average) is taxed. The taxable income share of 50 percent was apparently chosen since tax-exempt employer-paid pension contributions constitute half of the total pension contributions.

35

This proposal was accepted by both the Bundestag and Bundesrat in July. Municipalities would be compensated for the revenue foregone by receiving a larger share of VAT revenues.

36

Bareis Commission, “Report of the Income Tax Commission on the Tax Exemption of Subsistence Income and on Income Tax Reform”, Schriftenreihe, Heft 55, ed. by Ministry of Finance (Bonn), August 1995.

37

Mr. Uldall advocated in January 1995, a personal income tax code with a top marginal tax rate of 28 percent on personal and corporate income. The revenue loss of DM 120 billion would be financed partially by eliminating nearly all tax breaks (about DM 80 billion). G. Uldall, Proposal for a Reform of Income and Corporate Taxation, (Bonn), January 1995.

38

Some experts consider a tax on capital gains on stocks a double taxation of retained earnings.

39

The reduction in corporation tax rates in 1998 would be broadly revenue-neutral due to a planned reduction in some depreciation allowances in the corporate sector (see table).

40

Ministry of Finance, Finanzielle Auswirkungen der Steuerreform 1998/1999, June 1997.

41

See DIW, “Tax Reform 1998/99: No Success in Tackling Unemployment”, Wochenbericht 15/97 (Berlin: Deutsches Institut für Wirtschaftsforschung) April 1997.

42

According to DIW, the effective tax burden on enterprises declined from 37 percent in 1980 to 22 percent in 1997. The tax burden was measured by the ratio of the assessed income tax, the relevant part of the solidarity surcharge, withholding tax on interest income, corporate income tax, the wealth tax, and the local trading tax relative to gross entrepreneurial and property income.

43

For example, single tax payers without children and gross incomes of DM 30,000 would benefit from a 27.7 percent reduction in their tax liability; at a salary of DM 100,000 the tax cut would amount to 11.7 percent before rising again and reaching 25 percent for higher incomes. At an annual income of DM 200,000, taxes would be cut by 20 percent.

44

OECD, Taxing Profits in a Global Economy: Domestic and International Issues, (Paris: OECD), 1991.

45

The approach applied in OECD (1991) is based on the King and Fullerton (1984) methodology. But in contrast to the above mentioned analysis in Jorgenson and Landau (1993), which employs the “constant p approach” (fixing the pre-tax required rate of return of investment projects), following the OECD (1991) the “constant r approach” is utilized in this study. In the “constant r approach”, the return on alternative investments (before personal income tax) is used to anchor the calculations. The calculated effective tax rates on investment should, however, be interpreted as merely illustrative since they cannot capture all relevant features of the tax system.

46

The results reported here are predicated on the top personal income tax rate (see Table IV-5).

47

ZEW (Zentrum fur Europäische Wirtschaftsforschung), “Testimony in the Bundestag Finance Committee Hearing on Tax Reform”, May 14-16, 1997.

48

This calculation includes the reduction in the corporate tax rate, the solidarity surcharge and local trading tax on capital, and new depreciation rules. The new accounting rules, such as the write-up requirement, are not taken into account.

49

DIW, Tax Reform 1998/99.

50

RWI, “Testimony in the Bundestag Finance Committee Hearing on Tax Reform”, May 14-16, 1997.

51

See Leibfritz et al, (1997), “Taxation and Economic Performance.”

52

For these calculations, the total income tax relief of the proposed reform (1.1 percent of GDP) is assumed to be almost evenly split between relief on wage taxes and other (i.e. profit taxes) (Table IV-4); in addition, consumption taxes (VAT) would be raised by ½ percent of GDP.

53

Daveri and Tabellini (1997) show how endogenous growth features in an economy (such as a production externality where firms are more productive the larger the per-capita capital stock in the economy is) can create positive effects from tax reform on the real GDP growth rate.

54

For a review of the effects on the housing sector, see M. Kelle and R. May, “The Effects of the Tax Reform on the Housing Sector”, Bundesbaublatt, May 1997.

55

In 1996, an estimated two-thirds of all rental units financed at market rates were financed by private investors; M. Kelle and R. May, “The Effects of the Tax Reform on the Housing Sector”, Bundesbaublatt, May 1997.

56

Ibid.

57

See Deutsches Institut für Wirtschaftsforschung (DIW); Institut für Weltwirtschaft (IfW); and Institut für Wirtschaftsforschung Halle (IWH); Micro- and Macroeconomic Adjustment Processes in East Germany—Fifteenth Report,” 1997.

58

American Chamber of Commerce in Germany, “Testimony in the Bundestag Finance Committee Hearing on Tax Reform”, May 14-16, 1997.

59

See e.g. H. Kaiser, U. van Essen, and P. B. Spahn, “Income Taxation and the Supply of Labor in West Germany: a Microeconometric Analysis with Special Reference to the West German Income Tax Reforms, 1986-1990”, in Empirical Approaches to Fiscal Policy Modeling, ed. by Alberto Yeimler and Daniele Meulders, (London), 1993.

60

Mendoza, Razin, and Tesar, “Effective Tax Rates”.

61

The calculations are based on data from the OECD Revenue Statistics.

62

See OECD, Taxing Profits in a Global Economy, and King and Fullerton, The Taxation of Income from Capital.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Germany: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 1997: Issue 101
Publisher:
International Monetary Fund
ISBN:
9781451810318
ISSN:
1934-7685
Pages:
167
DOI:
https://doi.org/10.5089/9781451810318.002

GERMANY Wage and Profit Tax Ratios

(In percent)

Germany Personal Income Tax Schedules

GERMANY Income Taxation

(In percent of GDP)

GERMANY Statutory and Effective Average Personal Income Tax Rates

(In percent)

GERMANY Statutory and Effective Corporate Tax Rates

(In percent)

GERMANY Effective Average Tax Rates

(In percent)

GERMANY Tax Rates on Distributed Profits to U.S. Parent Company

(In percent)